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Budget deficits and real interest rates: a regime-switching reflection on Ricardian Equivalence

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  • Daniel Choi
  • Mark Holmes

Abstract

This paper investigates the relevance of the Ricardian Equivalence theorem for the relationship between the budget deficit and real interest rate. In contrast to the existing literature, we focus on regime-change over a long study period and consider nonlinearities. Using a Markov regime-switching model applied to two centuries of annual data, we find evidence that the US economy switches between a Ricardian Equivalence regime, characterized by an insignificant relationship between the adjusted primary budget deficit and real long-term interest rate, and a regime characterized by the traditional view of a positive relationship. We also find evidence that the transition probabilities between regimes are time-varying insofar as a weaker level of economic activity, a lower real interest rate differential between the US and abroad, or higher national debts, is associated with a weaker relationship between budget deficits and interest rates. Copyright Springer Science+Business Media, LLC 2014

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  • Daniel Choi & Mark Holmes, 2014. "Budget deficits and real interest rates: a regime-switching reflection on Ricardian Equivalence," Journal of Economics and Finance, Springer;Academy of Economics and Finance, vol. 38(1), pages 71-83, January.
    • Handle: RePEc:spr:jecfin:v:38:y:2014:i:1:p:71-83
    DOI: 10.1007/s12197-011-9212-9
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    More about this item

    Keywords

    Ricardian Equivalence; Budget Deficit; Real Interest Rate; Regime-Switching; E6; H6; E0;
    All these keywords.

    JEL classification:

    • E6 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook
    • H6 - Public Economics - - National Budget, Deficit, and Debt
    • E0 - Macroeconomics and Monetary Economics - - General

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